GSEs Fannie Mae & Freddie Mac on Death Watch


It’s clear now that Mr. Market has called Henry Paulson’s bluff. Fannie Mae (NYSE:FNM) fell 26% yesterday while cousin Freddie Mac (NYSE:FRE) was off 22%. The death/intervention watch for the GSEs is now round the clock. But what does it mean? And what happens next?

As the Barron’s story pointed out this weekend, both companies are effectively insolvent. But the charade continues. One reality check may come very soon. Fannie Mae has nearly US$120 billion in debt that matures by the end of September. Freddie Mac has US$103 billion in debt.

Can the GSEs roll it over? Who’s going to buy it? The Russians? Central banks? Private equity? Anyone. If they can’t fund their operations or roll over their debt, what point is there in having a government sponsored mortgage lender that cannot provide liquidity in the secondary mortgage market? (Shudder at what this means for the U.S. housing market…but the phrase ‘lower prices’ comes to mind.)

Do you get the impression that Hank Paulson doing his best Harry Callahan impersonation? Paulson must have hoped that by publicizing the fact that Treasury COULD buy equity in Fannie Mae & Freddie Mac and recapitalise them, it wouldn’t actually have to do it. That the words would have all the power of actions…without any action being taken.

But Harry Callahan had a .44 magnum, the most powerful handgun in the world. And the punk he was chasing down didn’t know if Dirty Harry had fired five shorts or six. It was a gamble the punk didn’t take because the magnitude of an imprecise calculation would result in a large hole in his head.

The difference here is the market knows that without direct nationalisation, the GSEs won’t last the month, and perhaps not the week. Common equity shareholders (those that are left) are headed for the gallows. This particular weapon-“Hey if we really need to we’ll buy $25 billion in preferred convertible”-ended up firing blanks.

But what really will they become if Treasury steps in now? We don’t know yet. We don’t know if it will restore any stability to the housing market. We’re pretty sure it won’t arrest the fall in U.S. home values. It may even precipitate a blow out in the spreads on GSE debt vs. Treasuries.

About the only thing you can be reasonably certain of is that the direct assumption of Government Sponsored Enterprise liabilities should be a negative for the U.S. dollar. Even if the Feds reorganise the company, liquidate the riskiest assets, and refloat it…there’s a lot of uncertainty. Markets don’t like that.

On the other hand, there is always the remote possibility that the appearance of a resolution to the decline and fall of the GSEs will give the stock market a shot in the arm. Irrational rallies are frequent when you have a sustained period of low-level crisis. But it all seems to be reaching a crescendo this week, doesn’t it?

In the bigger picture, that crescendo sounds like this: debt-financed consumption is not a long-term strategy for economic success. A minor, but building theme, might be this: buying common stock for less than underlying value (intrinsic value, net tangible value, or earnings power) is a sensible investment strategy.

Translation: keep your eyes on the resource prize. The stocks are in for some volatility as the financial markets wait to see which dominoes fall next. But the selling in equity markets simply makes some resource shares a lot more attractive (assuming, as we do, that the trends of urbanisation and industrialisation and rising per capita incomes in the emerging world are not derailed by the collapse of America’s Ponzi finance).

One interesting question now is if the Fed’s have a fast-enough reaction time to prevent deflation in financial assets from precipitating things like a bank run and a flight to cash. Paulson and Bernanke drew their weapons, hoping they wouldn’t have to fire. But now that they do, do they have any policy bullets left? Do they have the political will?

Our guess is that they do. The Fed is becoming a buyer AND a lender of last resort. It will manage the great collateral laundering in the financial markets, exchanging Treasuries for mortgage-backed and other dodgy debt (and expanding its balance sheet as much as it takes to accomplish this, something it has not yet begun to do… “I have not yet begun to defile myself,” as Doc Holliday says in Tombstone.)

Meanwhile, there’s no need to worry about “pushing on a string.” That refers to the inability of Fed policy makers to get money into the system by lowering rates. The futility suggested by that metaphor is based on the presumption that a middle-man, the bank, is necessary to get credit into the hands of people who will abuse it. If the banks won’t pass on the Fed’s easy credit on to consumers and corporations, then interest rates as a tool for deflating away debts aren’t effective.

But the stimulus package from last year showed the government is more than willing to bypass the banks and simply write checks to Americans. Drug dealers always give away free samples to get the user hooked. After that, it’s easy.

Mailing checks to Americans is a direct stimulus, although it’s hard to hide the nature of the system at that point. That means it can’t go on for long until people begin to lose confidence. But even then, public spending can be ramped up indirectly with an increase in the kind of massive public works that FDR pursued in the 1930s.

National rail system? Check! New Manhattan Project for oil shale? Check! A war to rebuild America’s infrastructure? Check! The checks are in the mail America!

Our point? The nationalisation of the GSEs may be a kind of starter’s pistol which causes the Fed and Treasury to roll out all their inflationary guns…and fire at will.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.


  1. FDR and public spending

    * Steve Saville, “The difference between good money and bad money”,, July 29, 2008:

    Economically, Roosevelt’s massive government borrowing/spending scheme – the same sort of ‘solution’ that many people are advocating today – was a total flop, for the reasons that anyone with even a basic understanding of economics would appreciate. For example, during Roosevelt’s first 6 years in office the Federal Government’s debt ballooned astronomically in response to government spending on an unprecedented scale, and yet the number of unemployed in America was higher in 1938 than it had been when Roosevelt was first elected President in 1932. The grandiose spending was, however, a political success, and thus fulfilled its primary objective.

    * David Leonhardt, “When Jobs Are Bountiful and Pay Isn’t”,, October 25, 2006:

    The Social Security Act of 1935, as the historian Edward Berkowitz has noted, laid the groundwork for the “Roosevelt recession” of 1937 and 1938.

    * George F. Will, Declaration of Dependence,, July 8, 2007:

    The Depression’s persistence, partly a result of such policy flippancy, was frightening. In 1937, during the depression within the Depression, there occurred the steepest drop in industrial production ever recorded. By January 1938 the unemployment rate was back up to 17.4 percent. The war, not the New Deal, defeated the Depression…

    * David Kennedy, “Freedom from Fear”, p.362:

    Roosevelt himself stood before the world in 1938 as a badly weakened leader, unable to summon the imagination or to secure the political strength to cure his own country’s apparently endless economic crisis. In the ninth year of the Great Depression and the sixth year of Roosevelt’s New Deal, with more than ten million workers still unemployed, America had still not found a formula for economic recovery. From such a leader, what could the democracies hope? From such a troubled nation, what did the dictators have to fear” (Kennedy, p.362).

    * Paul Johnson, “A History of the American People”, p.617:

    From the very start … Hoover agreed to take on the business cycle and stamp it flat with all the resources of government…

    [Hoover’s] policy of public investments prevented necessary liquidations. The businesses he hoped thus to save either went bankrupt in the end, after fearful agonies, or were burdened throughout the 1930s by a crushing load of debt. Hoover undermined property rights by weakening the bankruptcy laws and encouraging states to halt auction-sales for debt, ban foreclosures, or impose debt moratoria. This in itself impeded the ability of banks to save themselves and maintain confidence. Hoover pushed federal credit into banks and bullied them into inflating, thus increasing the precariousness of their position” (Johnson, p.619)

    “Revolt of the Middle Classes

    “”Printed and spoken abuse of government is seen and heard on all sides” – Carl Sandburg, 1932

    “In 1929, retrenchment was once again the predominant popular reaction, although it did not find immediate expression in the policies of government. The initial popular reaction to the depression after 1929 was to blame it on excessive government spending. Most citizens who worked in the private sector were obliged to deflate their living standards and household budgets in line with the contraction of the economy. Governments did not retrench as much as had previously been the case. Partly this was because Herbert Hoover was an advocate rather than an opponent of government action to dampen the business cycle. Hoover encouraged local governments to spend. He tried to keep wages up, including those for government employees. Nonetheless, there was a strong push to cut public expenses. Government spending was a small portion of the economy in 1929 by 1990 standards. Yet most citizens believed that they were getting little for their tax dollars. There were angry cries to slash spending. Harold Bettenheim, editor of American City magazine, an opponent of budget-cutting, observed:

    “It has become fashionable to decry government and taxes. Demands for indiscriminate budget-slashing are the order of the day. So-called economy leagues are springing up all over the country. Embattled taxpayers are organising strikes. Fluent orators are taking to the air to attack governments and the costs of government.

    “The American Municipal Association, an organizaton of city governments, lamented that “there are a great many people with whom the need for economy in government has become an obsession or mania that they have become violent and destructive opponents of all government.” Historian James T. Paterson remarked, “As tax revenue dwindled and unemployment increased economy in government became a magic word.”

    “In short, the initial reaction to the depression was a political demand to cut government spending. Candidates elected to governorships in 1930 and 1932 were generally advocates of economy in government. Paterson reports, “Retrenchment dominated the governors’ messages of 1931 and thereafter”… The national mood of retrenchment…helped elect Roosevelt… It was only after the economy had stabilized and the household sector ceased having to lower its own consumption that demands for retrenchment began to slacken” (James Dale Davidson & William Rees-Mogg, “The Great Reckoning”, pp.422-423).

    “…The notion that easy money is a magic tonic that can counter the forces of contraction is likely to seem alluring as an argument than it proves to be a fact. In 1929, neither the Federal Reserve nor the Bank of England could overcome the worldwide forces making for contraction just by manipulating numbers on their balance sheets. Economic historian Joseph W. Davis put it this way:

    “A careful reading of a mass of contemporary literature and an analysis of economic and financial developments in 1930 yield little or no support for the views (a) that Federal Reserve policy in that year was open to serious criticism, or (b) that flooding of the money supply by the Federal Reserve System would have effectively checked the contraction or moderated the current and ensuing collapse. With enterprise “collapsed,” the forces making for contraction were too strong to be overcome by the stimulus of artificial reducing short-term money rates below the very low levels actually reached” (Davidson & Rees-Mogg, p.350).

    “Contrary to the current wisdom that stupidly tight money turned the ’29 stock market crash into depression, accounts of 1930 speak of “extreme ease of money”… That what seemed to be easy money at the time was denounced later as “too tight”…” (Davidson & Rees-Mogg , p.444).

    “”The Federal Reserve policy of cheapening credit through the purchase of government bonds has been unable to make a dent in the conservatism of borrower or bank lender, in short, every anti-deflationary effort has yet to provide positive results”” (Editorial, Barron’s, July 11, 1932, quoted by Bob Hoye, How a currency can fight the Fed,, March 31, 2004).

  2. Dan how do I get to see a copy of the “The Australian Small Cap Investigator” without handing over my credit card number.

  3. That is a want to see a copy to see what I get before I get involved in handing over credit card numb

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